Chapter 7

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Time Value of Money

he time value of money is one of the most important concepts in personal finance decision-making. Money does not have the same value over time due to the fact that it earns interest. Consequently, a rupee today is not the same as a rupee in the future. Investing that rupee today yields an amount greater than the rupee in the future because of the interest or return that the investment generates. The interest rate or the rate of return is the link between the present and future value of money. The impact of the time value of money is dependent on the following three factors: The amount of money The annual rate of interest The length of time Another way to look at the time value of money is to view it as an opportunity cost. Spending rather than saving means lost interest. What you could have earned on that money has been lost. It therefore becomes important to know the interest rate on all your savings and investments to determine whether you should be saving or spending your money. Simple Interest The most basic method of calculating interest is the simple interest method. The other, more common method, of calculating interest is the compound interest method. Definition: Interest is the cost charged or payment made for the use of money. The simple interest method calculates interest on the principal only, without any compounding. In other words, the interest earned is not used to earn further interest. The elements used to determine simple interest are the principal, the rate of interest, and the length of time that the principal is invested or borrowed. The formula for simple interest is as follows: Interest = Principal Amount Annual Interest Rate Time Period or I =P R T

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For example, Rs. 2,000 deposited for two years at an interest rate of 5 percent per annum would earn Rs. 200 in simple interest (Rs. 2,000 x 0.05 x 2). The total amount received at the end of two years would be the principal amount plus the interest, or Rs. 2,200.

If the amount is deposited for less than one year, then the time period is divided accordingly. For example if Rs. 2,000 is deposited for a period of 9 months at an interest rate of 5%, then the amount of interest is calculated as below: Interest = Rs. 2,000 x 0.05 x (9/12) = Rs. 75 Compound Interest Compound interest differs from simple interest in that interest is paid not only on the principal but also on the accumulated interest, assuming that the interest is left to accumulate. The greater the number of periods for which interest is calculated, the greater is the accumulation of interest earned on interest plus interest earned on the principal. The formula for compound interest is expressed as follows: Future Value = Principal (1 + Interest Rate)n or FV = P (1 + i)n

where FV = Total future value (principal plus total compound interest) P = Principal (amount invested) i = Interest rate per year or annual percentage rate n = The number of periods at the interest rate Example: To illustrate the difference between simple and compound interest, assume that Rs. 100 is invested at an interest rate of 5 percent per year for five years and the interest is not withdrawn. If compounded annually, the compound interest earned would be Rs. 27.63, while the simple interest earned would be Rs. 25, as shown in the figure.

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The principal amount of Rs. 100 is used to determine the interest in the simple interest method, whereas compound interest uses the principal plus the accumulated interest from the previous year to calculate the interest for the next year. Thus, when given a choice between investing in a simple interest or compound interest account, you should choose compound interest, assuming risk and all other factors are the same. You can see that the difference between the compound interest and simple interest figures is quite significant if the amount is invested for a period of only five years. This difference grows quite rapidly as rate of interest increases. Consider this example: Compounding Effect as ROI increases:

Impact of Inflation Definition Inflation is the tendency of prices to rise over time. Learnings Through this example, you will see that as time goes by, the expenses will only increase, by the order of inflation. It is safer to ensure that you are geared up for it today. Inflation erodes the value of your financial assets. For example, suppose you are able to fulfil all your household needs for Rs. 10,000 currently. If the rate inflation is 4% p.a., it means that the same household goods will cost Rs. 10,400 next year. As we have seen the impact of compound interest, this would mean that in about 18 years the cost of all goods will be twice their current cost. What this means is that a rupee today is more valuable than a rupee in the future. Also it implies that all investments that you make should earn you a return that is in excess of the rate of inflation.

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The concept of time value of money is therefore important to understand for making the apprpriate investment choices. For instance, investment products that offer payments spread over many years are often far less attractive than they seem at first glance. Likewise, investment products that return money to you sooner offer better returns than those that defer payments till late. The time value of money is a double-edged sword. It benefits you by increasing the size of your savings but at the same time inflation will decrease the value of your holdings.

Chapter Review

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